Russia

During the boom years between 2000 and 2008, Russian GDP grew by almost 7.5% per annum. This boom was caused by two interlinked factors: The global economy was growing at a very rapid pace, and the price of crude oil rose throughout the period. When the financial crisis hit major parts of the world, Russia’s economy was badly affected along with everybody else, but subsequently Russian growth has been slower than before the crisis. In addition, Russian GDP growth has decelerated almost continuously from 2011 onwards. (Figure 1)

Figure 1 Russia’s GDP growth

Source: Rosstat and own calculations

There was no obvious single reason for this slowdown, but some important factors should be noted. First, Russia’s working-age population had started to decrease, which automatically slows down GDP growth, ceteris paribus. Second, Russia’s fixed capital investment remained low, between 21% and 22% of GDP after the global financial crisis. While this would not be problematic for a country like, say, Germany, Russia’s investment ratio remained much below rapidly growing emerging market countries. Third, growth in productivity had become much slower already before the global financial crisis (Voskoboynikov and Solanko, 2014). Last, the price of oil remained high, but it did not increase as it did between 2000 and 2008.

Deryugina and Ponomarenko (2014) use a large Bayesian VAR model to assess the relative importance of various macroeconomic factors in explaining the evolution of Russia’s GDP. They find that the oil price together with demand from the EU are enough to forecast and explain most of the short-run movements in Russian GDP. Rautava (2013) notes a similar dependence on the price of oil. Even more interestingly, he notes that Russia’s trend growth halved to approximately 2% after the global financial crisis.

Role of oil

It is difficult to overstate the importance of energy prices for the Russian economy. Crude oil, oil products and natural gas brought 70% of Russia’s export revenue in 2014, and the energy sector provides the Russian Federation with more than 50% of its tax intake. Figure 2 illustrates the tight connection between the price of oil and Russia’s exchange rate.

Even after the introduction of sanctions in July, the Russian currency and financial markets remained relatively calm, but the rouble started its steep depreciation when the price of oil plummeted. Connection works in the other direction as well, of course. When the price of oil stabilized and recovered somewhat in February and March, 2015, the rouble reacted in the same direction as well.

Long-run growth slower than before

Unfortunately, Russia’s long-run growth prospects are not very rosy either, especially in comparison to the development in the recent years. We know very well about the evolution of the working-age population during the next 20 years, as almost all people coming into working-age have already been born. According to the UN prediction, Russia’s working-age population will decline from 90.7 million in 2015 to 78.7 million in 2035, which translates into -0.7% change annually on average.

Figure 2 Price of crude oil and the rouble

Even if one assumes that the capital stock will grow somewhat – say by 0.3% per annum, which is higher than recently – for the next twenty years, and total factor productivity also rises at a relatively rapid – but decelerating – pace, Russia’s GDP growth will be below 2% for the next twenty years (Table 1). This is clearly below what Russians have become used to in recent years. Also, Russia’s share of global GDP continues to decline. Moreover, Russia’s growth needs to be driven by total factor productivity. Voskoboynikov and Solanko (2014) estimate that it grew by 2.5% per annum between 1995 and 2008. Therefore, keeping Russia’s growth relatively fast at higher income levels might be difficult.

During the boom years of 2000-2007 Russian economy grew on average by more than 7% p.a. While the global economy also expanded vigorously, Russia’s growth was boosted further by ever-higher oil prices and productivity improvements especially in the services sector.
Russia’s rapid GDP growth meant that Russians’ average standard of living also increased during this time, and by 2008 per capita GDP (at purchasing power parities) was 34% of the corresponding level in the US from 21% in 2000. Partly this rapid growth was a rebound from the economic crisis of 1998, but growth was also helped by restructuring of the economy towards services, which were very much underdeveloped during the Soviet times and early years of the economic and political transition. Moreover, productivity growth in the services was also fast, especially in the high-skill sectors such as financial intermediation and business services, which is natural given the relatively low starting level.

However, growth during the boom years was not only driven by productivity improvements. According to a recent Discussion Paper published by the Bank of Finland Institute for Economies in Transition (Marcel P. Timmer and Ilya B. Voskoboynikov: Is mining fuelling long-run growth in Russia? Industry productivity growth trends since 1995, BOFIT DP 19/2013, http://www.suomenpankki.fi/bofit/tutkimus/tutkimusjulkaisut/dp/Pages/dp1913.aspx) growth in the capital input has also accounted substantially to the growth in value-added. Moreover, growth in labor input has accounted for almost equally large share of value-added growth. At the same time many sectors where productivity growth has been very low, such as mining, have been able to increase their share of the economy, as they have been able to attract more capital and labour.

Lower growth in the future
In 2009 Russian economy suffered from the global financial crisis, but its post-crisis growth has been clearly slower than many expected, even though the price of oil soon returned to over $100 per barrel. While the average GDP growth between 2010 and 2012 was 4%, growth continued to decelerate. In late 2012 and early 2013 quarter-on-quarter growth was practically non-existent. While the slowdown in growth has partially been cyclical, it is also a sign of clearly lower growth in the potential output.
First, working-age population is already declining, and at the same time unemployment is very low. Officially the unemployment rate is around 5%, which in practice means full employment. Unless retirement age is increased soon, labor supply continues to decline, which will have a negative effect on future growth.

Second, investments are also declining. Between 2010 and 2012 the average share of gross fixed capital formation in GDP was 21.8%. This is below the average investment ratio of other middle-income countries (see Figure 1), many of which are currently growing faster. Moreover, during the first half of 2013 investments actually declined year-on-year, and especially large energy as well as infrastructure companies cut back their investments. At the same time capacity utilization rates are even higher than during the boom years of 2006 and 2007 (Figure 2). This tells us that Russian companies do not view their future prospects favorably, and the large capital outflows basically tell the same story. During the past quarters net capital outflows have averaged some 2.5% of GDP.

Figure 1 Share of fixed capital investments in GDP and per capita GDP (middle and high-income countries
(Click the image to zoom in)Source: World Bank World Development Indicators database

It is noteworthy that even relatively high oil prices have not been enough to boost Russia’s growth in the recent quarters. It seems that the uncertain global environment and Russia’s own well-known problems with business environment are hindering investments. It is especially noteworthy that Russian companies and investors are deeming investments into Russia lacking when taking into account the expected profits and perceived risks.
The aforementioned factors have led many analysts inside Russia and outside it to drastically reduce their estimates of Russia’s long-term growth potential. Many of the estimates seem to cluster between 2.5% and 3% p.a. While this is still quite respectable in comparison to many EU countries, it will mean substantially slower increase in incomes and delayed convergence with the OECD countries. Also, slower growth may at some point be in conflict with the many fiscal responsibilities of the public sector.

During summer, we have seen – and still see – quite some nervousness about the so-called BRIC countries in the emerging world – and some contagion to a couple of emerging market countries that also try to catch up, like Indonesia and Turkey. Three questions seem to be particularly interesting:

¤ Is the current nervousness about BRIC countries really motivated?

¤ Why do we have these contagion effects to several countries – to some extent similar to developments during the Asian crisis of 1997-98?

¤ Do we currently see the beginning of a real BRIC crisis which may turn much worse and which will also mean a notable downsizing of BRICS countries’ potential (trend) growth?

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BRIC is a term that has been coined in the beginning of the past decade by an economist from Goldman Sachs, a major American investment bank. BRIC –nowadays BRICS since South Africa joined the “club” a few years ago – are the initial letters of Brazil, Russia, India and China. I always considered the BRIC(S) thing mainly as a marketing instrument for asset allocation. In reality, these countries did not have enough in common to put all four eggs in one basket. Relatively good economic growth during a couple of years and a large population were simply not enough to “harmonize” analysis and investment strategies for these countries.

By the way, similar simplifications could be recognized already in the latter part of the 1990s when Eastern Europe Equity Funds and Asia Equity Funds were launched as attractive alternatives for investors. At that time, countries with different structural and institutional conditions were put in the same investment baskets, too. This proved to be wrong after some time. BRIC supporters from all over the world could have learnt from these examples.

Many experts see the main reason for the current “BRICS problems” in the expectations of – right or wrong – forthcoming cautiously rising interest rates in the traditional industrial world, especially in the U.S. Such a development could (probably) lead to (further) substantial capital outflows from BRIC countries to North America (the U.S.) and (parts of) Europe, according to the BRICS pessimists.

This explanation, however, is too fluffy. A deeper analysis of the BRICS problems is urgently needed. Are there fundamental reasons for the contagion? Or have we got a new example of overreacting financial markets?

Let’s first look at possible common characteristics of the four BRIC countries – South Africa is excluded in this context – that may have caused negative feelings about the BRICs as a group.

¤ Portfolio shifts? More financial inflows to the traditional OECD countries – at the expense of portfolio investments in emerging markets because of expected gradual, cautious monetary tightening by mainly the Fed (with the assumption that the four above-mentioned, leading emerging markets are running the highest outflow risks)
–> could partly serve as an explanation because the four above-mentioned BRIC countries represent the economically four most important emerging economies.

¤ Substantial slowdown in GDP growth? A rapid weakening of GDP could actually been noted in only two BRIC countries during the past year – in Russia and in India. Brazil even stands for growth improvements four quarters in a row after a couple of growth stimuli.

The last GDP-growth numbers for the BRIC countries look as follows:

Brazil: 2013, q2: 3.3%; 2012, q2: 0.5% –> coming down from around 9% in early 2010

Obviously, GDP growth has not developed simultaneously in all BRIC countries in the past few quarters – but more visibly on trend during the past 3-4 years. This is indeed true for all BRIC countries. This development strengthens the view that more positive growth signals that currently come from the U.S., Japan and some European countries to a high extent more strongly triggered the worsening cyclical view of financial investors on BRIC countries than any other single factor. But looking at GDP-growth developments since 2010 gives also certain reasons to find structural components in the now more dampened growth outlook for BRIC. Thus, we have–> an obvious cyclical BRIC phenomenon combined with certain negative structural components (like, for example, demand from Southern Europe) – and not a pure structural problem.

¤ Current account problems? Current account deficits are frequently used explanations for the problems of the BRICs – and the need for foreign capital inflows for financing these deficits. But only India has a (somewhat) too high deficit ratio in relation to GDP (around -4.5-5% in 2013). Brazil’s predicted deficit in the range of 3 ¼ – 3 ¾ % for 2013 is a little bit high but should not be as scaring as markets consider the entire BRIC situation. China and – probably – Russia should even continuously manage current account surpluses which takes us to the conclusion
–-> that current account problems should not really be considered as a major common problem for all the four major BRICS countries. From this point of view, the contagion effects that have been created by global financial markets, seem to be overdone. But they exist!

¤ Insufficient fiscal stability? Public debt – annual and total – is, of course, an economic indicator that all country analysts watch very carefully. In this respect, Russia and – probably – Brazil seem to have their structural fiscal conditions roughly under control. China seems to be on the safe side for the time being – at least when official numbers are analyzed (about which, unfortunately, one may have serious doubts). India finally has been affected by negative fiscal developments since a long time ago. Thus, the question is–> why well-known fiscal conditions – which are not really bad in all four BRIC countries – suddenly should lead to general worries on global financial markets. We probably can find psychological explanations in this respect. This urges for deeper analysis.

¤ Lagging structural reforms?Sure, all emerging countries have more or less burdening structural or fundamental shortcomings. What concerns Brazil, one may mention, for example, insufficient productivity gains and declining international competitiveness, lagging education and pension systems, etc. Furthermore, Brazil is nowadays increasingly competing with – currently – a more reform-minded and economically improving Mexico. Russia suffers from a significant number of institutional deficits – the financial system and support of entrepreneurship included – a too large role for the government/state in the economy and a too high dependence on the energy sector.

India,on the other hand, has more obvious fiscal problems than Brazil, Russia and China and more growth-impeding infrastructural shortcomings which are – also according to my own micro experience from these countries – much more serious than in the three other large emerging countries. The same conclusion can be made about the Indian current account deficit. Last but not least China. Nobody questions that China’s economy has proceeded substantially in the past two decades or so. But we know also that China despite all economic progress still suffers from lots of structural shortcomings particularly when it comes to microeconomic and institutional conditions – unfortunately combined with worrying transparency shortcomings.

Putting together the reflections of the above-mentioned structural thoughts means that structural shortcomings exist in all four BRIC countries
–> but without strong logical correlation for motivating sudden distortions and disappointment for the BRIC region as a whole as we have seen in the past months.

Conclusions

In my opinion, the recent negative pressure from global financial markets on the artificial BRIC group – South Africa is excluded in this analysis – should not be considered as the result of a completely consistent and logical approach. Several factors point also at psychological overshooting. Common issues for all four BRIC countries are the insufficient demand for their exports, mainly caused by weak global demand – an issue that probably is characterized by both cyclical and structural dimensions – and the expected future monetary tightening in the U.S.

I have also found that several negative macroeconomic indicators do not point at the same degree of imbalance in all four BRIC countries (if at all).Consequently, it can be singled out that certain psychological overreactions are/were in place.

For this reason, I would argue that current developments have re-set the previously overdone BRIC enthusiasm – to some extent the result of artificial financial marketing – to a more justified stance of growth expectations (without considering the issue of the middle-income trap). This should induce some reduction of previously exaggerated expectations of BRIC countries’ potential GDP growth – but probably less dramatically than described in many recent analytical pieces. Again: Almost all countries have their own characteristics. This makes it most doubtful to put several “(emerging) country eggs” in one single analytical basket.

However, occasional negative contagion effects from one country to another will most probably be inevitable in the future as well. Here we have another example that clarifies the need for more research in behavioral finance.